Outsourcing and the Banks

Executive Summary

The article examines the growth of the outsourcing phenomenon in the financial services sector and looks at the next wave of “value-added” outsourcing, where banks seek to outsource more highly skilled jobs done by higher-paid employees, thus gaining more from wage arbitrage. The emphasis is on:

• The benefits of taking the long view (strategy) rather than looking for quick piecemeal gains (tactics).

• The value to be gained from outsourcing more highly paid work.

• The erosion of the benefits of “simple” process outsourcing due to rising salaries in major outsource markets like India.

• The impact of consolidation through M&As, when several outsourcing contracts may need to be rationalized.

• The differences between onshore, near-shore, and offshore outsourcing.

Back to top

Introduction

The major banks in developed markets have been extensive users of outsourcing and have been at the forefront of pushing the boundaries of outsourcing onshore, near-shore, and offshore (near-shore in this context refers to outsourcing to a country location that has a time differential of not more than three hours from the bank’s main business locations). High-profile examples here include Barclays Bank’s outsourcing arrangement with Accenture, and Citibank’s outsourcing operations, which it sold to the Indian outsourcing giant, Tata Consultancy Services (TCS), in October 2008 in a deal worth US$505 million.

In 2004 Barclays signed a £400 million deal with Accenture to outsource applications development for its UK banking systems. A year earlier, in a £230 million deal, it outsourced its desktop management to IT services firm EDS.¹ Citibank’s sale of its outsourcing arm was planned prior to the global downturn, since in the spring of 2007, while the world was still in a boom phase, Citigroup said that it wanted to cut US$10.4 billion off its spending over the next three years. This would be achieved by disposing of its own outsourcing operations and instead moving more of its jobs to outsourcing providers offshore. As part of the deal with Tata, it was agreed that TCS would provide offshore services to Citi, using Citi’s former operation, in a contract reportedly worth US$2.5 billion over nine and a half years.²

Today it would be difficult to find a major or even a mid-range bank that does not have fairly extensive outsourcing at least of its IT function, and generally of some business processes as well.

Back to top

The Development of the Next Wave of Outsourcing

The development of the next wave of outsourcing centers on the idea of moving up the value chain and outsourcing higher-end, more highly skilled work. Much of the impetus for this came from the big investment banks just prior to the current global banking crash. There was tremendous pressure on banks to increase margins and profitability and to cut costs, and the way to do this was seen to be to move more highly skilled work offshore. There are very substantial salary savings to be made by organizations that can achieve high-value outsourcing to low-wage economies.

The challenges are formidable, but the process is now well underway and it seems inevitable that there will be a greater use of shared service centers—locations that support more than one department or business unit for the same organization. In the late 1990s and until around 2000–02, banks found that they could outsource moderately skilled parts of retail banking offshore and achieve savings of the order of 40–50%, as reported by market analyst organizations such as Gartner and Forrester Research.

Salary pressures in offshore countries like India and the Philippines have reduced the level of savings that can be achieved for moderately skilled outsourcing arrangements. On top of this, for UK banks, the depreciation of the pound has further eroded savings from overseas outsourcing (translating pounds into almost any other currency requires more pounds today than it did two years ago, so those contracts have become more expensive).

Back to top

Large Savings Lie Ahead in New Wave Outsourcing

However, price pressures simply add to the banks’ incentive to move more highly skilled, and therefore higher-paid, work offshore, since this is the area where really substantial savings can be made. In the case of banks involved in securitization and merger and acquisition (M&A) work—in other words the old-style investment banks, and whatever may come along to replace them, since they have now all switched to become deposit-taking institutions—the high fees and high remuneration structures in those banks could generate savings of up to 65% through offshoring. Although bank remuneration packages have come under pressure due to the economic downturn, the salary differences between more highly skilled functions and clerical functions are still considerable. From the banks’ point of view, another really attractive feature of offshore working environments is that they are free of the bonus culture that permeates the financial services sector in developed economies.

Generating maximum savings, however, is not always the major driver for offshoring. Increasingly, particularly in a world driven by compliance issues, organizations are looking to achieve greater standardization of processes—i.e. having all operations of a certain kind run from a shared services center, or “center of excellence.” This term is used for a specialized central function with a developed ability to execute specific business processes, such as accounts payable, to a high level. By using such a center to service many business units, the company gains efficiencies and economies of scale. A center of excellence enables standardized procedures to be shared throughout a global organization. At KPMG we are talking to global chief finance officers (CFOs) about outsourcing to Asia precisely in order to drive greater compliance and control. That such an arrangement does also produce cost savings is seen by some organizations as a secondary rather than as the primary benefit.

Back to top

Rationalization of Existing Arrangements Remains a Key Driver

Another major trend is the rationalization of existing outsourcing arrangements. The world has just passed through a boom period of M&A activity. As a consequence, large organizations have acquired businesses which themselves have outsourcing contracts of one type or another. When sales activity is high, companies tend not to have the time to undertake the rationalization exercises that everyone involved can see would make sense—if only the management resources were available to tackle these projects. However, in a sharp downturn, sales pressure evaporates and rationalization moves up the agenda.

What we have seen—and will continue to see as a consequence of the turmoil in the global banking market—is a number of acquisitions and mergers as the sector consolidates and weak banks are bought by stronger banks. Again, this means that the acquirer finds itself inheriting a range of outsourcing arrangements, some of which might be better, or more far-reaching in scope, than it has so far initiated itself. All of this tends to stimulate management thinking in the sector about the role of outsourcing at a global level. One inevitable consequence of this as we go through 2009 and into 2010 is that there will be a step increase throughout the sector in outsourcing, together with a good deal of retendering activity as companies look to rationalize and get best value from existing contracts.

At the same time as this is going on, at the national level there are already the usual recessionary calls for protectionist measures. The outsourcing industry is going to have to make its case in the teeth of government, political, and public pressures for jobs to be kept onshore. In the case of banks that are in receipt of public funds, with government bailout packages of one kind or another, there is already considerable pressure for them to spend money “at home” rather than on jobs in Asia. These pressures can be expected to have a dampening effect on the global outsourcing market, though how far they will offset the strong drivers toward outsourcing remains to be seen.

Back to top

A Return to Tactical Outsourcing

We can expect a short hiatus in outsourcing over the spring and possibly summer of 2009 as financial services organizations across the developed world take stock of where they are and formulate their strategies for going forward. Having made some huge mistakes in their investment strategies, many organizations will be very mindful of some of the classic mistakes in outsourcing that have been made over the last 10 years.

Tactical outsourcing, for example, where an isolated function such as credit card payment collections, was “lifted out” of the organization and placed offshore, is now demonstrably not the way forward. This kind of outsourcing may well have achieved short-term savings of the order of 40% for the parent organization. However, it did so at the cost of creating dislocations in “ownership” and responsibility for the function that in many instances have come back to haunt the company concerned. The process, once isolated in this way, stops growing and evolving along with the parent organization, and it stops improving. Also, you get divergence away from developing group policies and standards, and returning to such a function and bringing it back up to best-practice levels becomes a real challenge.

Instead of this tactical approach to outsourcing, management teams are now thinking much more strategically. Does a bank simply outsource its accounts payable function and gain a quick return from that, or does it sketch out a model for the next three to five years that will see it moving 60% of its finance function out of a high-cost arena? Taking this second approach gives it the chance to create a more globally integrated operation, and this in turn allows management to start thinking about driving global compliance and global design and delivery of processes. Instead of outsourcing a bit here and a bit there, the organization can start to think about generating a much more coherent and strategic approach.

Back to top

The Future Lies with Strategy Rather than Tactics

It is important to realize here that, for a large organization, this need not mean outsourcing everything to one location. What it means is having a governance model that is coherent and makes sense for the medium term. Under this kind of model, management can ensure that there are named, responsible teams for each of the sub-functions and that their linkages and dependencies with the rest of the organization are fully understood. It is crucial that sub-processes and functions like this are owned by particular senior management parties end to end across the globe.

Once an organization starts to take this strategic approach, it becomes clear that there are various options for outsourcing, including:

• Onshore, with a shared service center, say, in the same country.

• Near shore, where the service center is within two or three hours’ reach of the home country, which makes it easy for management to commute and keep close contact with an evolving function. Often with accounts preparation and management accounting, for example, the finance function will need to go to subsidiaries to help the management teams there to understand what the numbers are doing. Again, near-shoring keeps the function within reach of this kind of activity.

• Offshore, where parts that can be done much further off are outsourced to distant centers, although as part of a coherent overall design.

It is often the case that when large organizations in the financial services sector begin to take a strategic view of their business processes, it becomes clear that a great deal of work is being done at very high cost within the business. This is because it is being done by very expensive people located in some of the highest-cost office premises in the world. By moving the work to a shared service center onshore, which may well still be wholly owned by the organization, management can start to take a more holistic view about how their business—including the finance function, the design function, the product origination function and so on—should look in three to five years.

It has taken banks a decade to get round to the idea of combining shared service centers with outsourcing to generate a more complete picture of what the organization could look like in the medium to long term. It is quite possible, for example, for an organization without a strategic vision to take too much work out of a country. There is a lot to be said for keeping a critical mass of expertise in any function within the country.

One of the difficulties with outsourcing to multiple foreign centers is that much of the responsibility for operations delivery moves away from the core business, so you lose some of the benefits that come from the cross-fertilization that happens when units interact. Another difficulty is that there is much less scope for local deviations away from the standard. What rapidly becomes clear is that the cost of deviating from a proven standard rapidly outstrips whatever local advantages people think they are deriving from allowing the deviation. Businesses, in other words, get much better at weighing the cost and the risk impact of deviations from standard processes, so centers of excellence tend to bear down hard on parts of the business that want to go their own way. It is still possible to accommodate this, but it has to be signed off by people with authority at a very senior level in the organization.

Another difficulty has to do with change management. Often projects are properly scoped at the outset, but things go wrong because the company undergoes fundamental changes and the way the organization then interacts with the outsourcing provider causes costs to ramp sharply. At its worst, this moves us back to the 1970s model of IT, for example, where what IT can or cannot do constrains the business’s ability to grow. This is why it is vital for the service-level agreements and support agreements that frame outsourcing arrangements to be properly constructed.

The standardized process approach with highly skilled work, where the service is commoditized and priced accordingly, does not work. You cannot commoditize R&D for example. Again, thinking contracts through properly and putting the right infrastructure in place is critical.

Back to top

Conclusion

There are still tremendous gains to be made from outsourcing and some very powerful drivers continue to push financial service organisations to intensify their use of outsourcing to generate both profitability and organisational control. However, the process takes real commitment and skill to achieve the target savings that organisations are looking for. This is an area where strategic planning really does pay dividends.

Back to top

Making It Happen

Any move to outsource a major function requires considerable work and planning, together with the appropriate consultancy support. Key decisions include:

• The control and responsibility of delivery to service-level agreements.

• The shape and location of the outsource contract.

• The relationship between what is being outsourced and the rest of the client’s business.

• The flow of data.

Outsourcing is a challenging project and requires top-rate project management and planning skills to generate the full range of expected benefits.

Back to top

Notes

¹ www.vnunet.com (June 23, 2004).

² Information Week (October 8, 2008).

Back to top

Back to Table of contents